Analyzing contango histogram: Are you doing it correctly?

We have added the contango histogram to the SpreadCharts two years ago. At that time, it was a great innovation that, as expected, kicked out a huge interest of traders. I have also explained our histogram in my articles. Histogram has become a helpful tool for many traders, which is of course a great pleasure for us. Recently, however, I have noticed that some people do not use the contango histogram in the right way. I even got a lot of questions on this subject, so I decided to explain everything through today’s article.

Incorrect use

Some traders misidentify the contango histogram showing continuous contracts line with the development of a particular spread. They look at a spread, for example NGQ18-NGN18, and they try to identify on the histogram chart a combination of continuous contracts that are currently belonging to a given spread. For example, the above-mentioned gas spread corresponds to the combination of F1 and F2. That is the first-time line in the graph (blue columns).

They compare the current value of the contango (vertical line) to the historical distribution and derive where the NGQ18-NGN18 spreads can move to. However, this use is totally incorrect and can lead to misleading conclusions and, consequently, to unnecessary losses. I’ll explain why.

The F1 and F2 combination now really matches to the specific spread. The distribution of contango, that is represented by the independent columns in the chart, is calculated from continuous contracts. While the combination of F1 and F2 now belongs to the relatively quiet summer season spread NGQ18-NGN18, a couple of months ago, the same combination of F1 and F2 had been for example the NGJ18-NGH18 spread. This is a very wild spread at the intersection of the winter heating season and the non-heating season. Its movement is often influenced by frosts at the end of the winter. This is completely different from the NGQ18-NGN18 spread, because there are no frosts in the summer.

The contango histogram chart, however, is calculated from both of these spreads(and many other combinations). It makes no sense to compare a particular spread with the contango histogram chart, because we compare apples with oranges. When comparing the current value and a contango histogram with a historical data, we must be very careful. Especially with commodities where supply and demand are unevenly spread over time. Which is undoubtedly the case of gas. And it is true for most physical commodities, such as grain, meat, most energies, and other.

How to use contango histogram correctly

Contango histogram serves us to evaluate the overall market situation. As you could see in Spread reports or in the articles, I always look at multiple combinations to suppress the influence of the wavy term structure during my analysis.

Thus, the Contango Histogram is a tool to gain insight into the market as a whole. Definitely it cannot be applied to the analysis of a particular spread.

Recently, the main architect of SpreadCharts.com and the author of the mentioned charts, Pavel Hála, expressed himself at the Quastic Forum on this topic:

“With regard to the contango combinations, Elena pointed out that she saw this incorrect way of analysis with several persons. Contango histogram serves to gain insights about the distribution of the contango on the given market and the given part of the term structure within some longer period. The given premise is longer period, which erodes the influence of the jump and discontinuity on the term structure of the given market on the statistics results. Even so, one must be cautious in interpreting when comparing the current value of contango with the distribution at commodities, where the supply / demand is clearly inhomogeneous in the time, which is true for most physical commodities.

I will show it on an example. The combination of F3 / F5 on corn currently corresponds to the ZCK19-ZCZ18 spread, a relatively conservative spread from the new harvest. However, the statistics are comprised of continuous contracts, so F3 / F5 will be within few months totally different spread, for example – ZCZ19-ZCN19. This is the spread between two harvest, and its value is usually based on other factors other than F3 / F5 today. Within few months, the F3 / F5 combination will be presented by other contracts. If someone follows contango histogram for a certain combination of continual contracts and he is trying to squeeze it on some particular spread, the he mixes apples with oranges and the result that he has received is totally out of order. For this reason, we have the analysis of carrying charges, and where it is not available, we use at least a detailed seasonal analysis.”